A few weeks ago I wrote an article for Seeking Alpha discussing whether or not it might be an opportune time to short gold the commodity and go long a basket of gold producers. My thinking was that the stock prices of the gold producers had greatly lagged the increase in the commodity and that either the stock prices needed to move up or the commodity come back to them.
This week I got some support for this notion from Canada’s best known hedge fund manager Eric Sprott of Sprott Asset Management. Sprott was pounding the table for gold early in the last decade and got in on the ground floor of the current bull run. His firm is a source of financing for all kinds of resource companies in Canada and he has some excellent insight into the sector.
Now Sprott is suggesting that investors should reduce exposure to the commodity and shift those funds into gold equities which have greatly lagged the rise in gold. Sprott provides the following numbers that I’ve pulled from the link above:
Last week, the HUI Gold Index marked a new all-time high as it surpassed 600. Recent gold equity investors were undoubtedly happy with this move, but for longer-term holders, the recent strength is actually somewhat disappointing ... while the gold price has almost doubled since early 2008, the HUI Index has appreciated by a mere 22% over the same period. If the HUI was justified at 500 in early ’08, it should surely be justified at 1,000 today, given the appreciation of the gold price over that time.
He further provides specific guidance as to what Sprott is doing with their investment dollars:
In many of the funds we manage at Sprott, we’ve transitioned out of gold bullion and into gold equities to better participate in the continuation of the trend indicated above. As long-time investors in this space, we can assure you that the production growth rates will be significantly higher in the junior stocks. They continue to trade at discounted valuations, and we believe they offer the best opportunity to build exposure. Margin expansion is the key metric for this industry, and the market is now acknowledging the miners’ improvement in margin capture – which has occurred despite the increase in capital and operating costs. We meet with a large number of gold mining management teams on a weekly basis, and based on those meetings, it appears that the average cost of producing an ounce of gold today, all in, is now around $800. At $1,200 gold, these companies can capture roughly $400 in EBITDA. At $1800 gold, however, they’re now capturing $1,000 per ounce in EBITDA - representing an increase of 150% in profit margin. That is significantly far above what any other equity sector has been able to generate over the past year.
Amazingly – despite this new reality for gold producers, we are still finding opportunities in select gold and silver mining companies that can be purchased today at 2-3 times their 2-year-out forecasted cash flow. These multiples are based on the current gold and silver spot price, and if these companies hit their production targets, and gold and silver continue their appreciation – we may discover that these stocks were trading at less than 1 times 2-year-out cash flow today. Having been in the business for many years, we can tell you that investing in a stock at 1 times 2-year-out cash flow tends to be a winning proposition – let alone in an industry that literally mines the world’s reserve currency out of the ground.
He makes a compelling case. And if you believe that gold is going to stay at current prices or go higher then I think simply being long gold miners at this point is a no brainer, because having looked at a handful I can tell you that there is no way their valuation reflects the current commodity price.
I’m still hesitant to buy into high gold prices for an extended period so I’m likely going to look for a hedge on the commodity but exposure to the equities. One gold miner I’ve been looking at is one that is about to make a giant step from the development stage to the production stage.
Banro Corporation (BAA)
Banro is a Canadian based gold development company. It has four 100% owned mining concessions along a major gold belt in the Democratic Republic of Congo. The company is on the verge of major production from its phase 1 gold mine at its Twangiza project.
As of Aug. 15, 2011, Banro announced that it is still on schedule for fourth-quarter production and the company is fully financed through completion of the project.
Banro reminds me of another investment that I exited from this spring. The company is called ATP Oil and Gas and while I held it the company was developing a step change oil project in the Gulf of Mexico. As the completion date of the project neared the stock price drifted up in anticipation of the news as investors wanted to get in before a formal announcement of completion. From about $13 in February of 2009 ATP’s stock price hit $23 in April.
Banro is now like ATP was then, about three months away from completion and I think the stock price could have a healthy run between now and then. Happily, Banro, unlike ATP is not loaded with debt and is fully financed through the completion of the project at which time they will have ample cash flow.
My point is that now might be a good time to get into Banro if the price is right.
Of course having a catalyst is great, but if the stock is not undervalued then it doesn’t matter. To get an idea if Banro is trading at a discount to intrinsic value we need to look at its resources:
Banro’s Resources:
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Twangiza and Namoya Banro are known reserves and are development projects. Lugushwa and Kamituga are riskier as they are exploration. My thinking for resource companies is that it is a good deal if I can buy the stock at or below the value of the booked reserves and then get a bunch of high impact exploration upside for free.
As a first stab at a valuation to see if Banro is worth pursuing further I ran the following numbers so that I could see what the enterprise value is per ounce of gold:
- 209 million fully diluted shares
- $4.70 current stock price
- Market cap of $982 million
- Enterprise value when you back out the $60mil of cash = $932 million
- 6.7 million ounces of gold reserves
- Market valuing at $940 / 6.7 = $140 per ounce
If you include the reserves and resources it is more like $940 / 11.3 = $83 per ounce.
Attention grabbing numbers with gold at $1,800 per ounce and capex spending on the first phase of Twangiza pretty much completed. Cash cost over the first five years of Twangiza is expected to be $356, so Banro has a pretty low development cost.
Recent African Gold Miner Transaction Multiples
I was able to find some recent African gold company transactions to use as an estimate of the attractiveness of Banro’s valuation:
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The most useful way to look at this is as follows:
- Average price per reserve - $440/oz
- Banro current implied price per reserve - $140/oz
- Suggested upside for Banro stock price $440/$140 = 3.14x
- Average price per resource - $246/oz
- Banro current implied price per reserve - $83/oz
- Suggested upside for Banro stock price $246/$83 = 2.96
When you look at those two multiples it clearly does suggest that Banro is very attractively priced.
But the valuation looks even better when you consider that the transactions that I’m using occurred at an average gold price of $952 AND the current gold price is almost double that the Banro valuation looks extremely attractive.
I would of course caution that this is a company operating in Africa and therefore subject to considerably more risk that a domestic producer. I think it is clearly cheap, but not one for a concentrated position but rather a basket approach.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
